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March 18, 2013

What I Learned at Our Compliance Conference, Pt. 2: What SEC Examiners Are Pursuing

More On Legal & Compliance

from The Advisor's Professional Library

Whistleblowers
A whistleblower is any individual providing the SEC with original information related to a possible violation of federal securities law. The Dodd-Frank Act established a whistleblower program that enables the SEC to reward individuals who voluntarily provide such information.

Using Solicitors to Attract Clients
Rule 206(4)-3 under the Investment Advisors Act establishes requirements governing cash payments to solicitors. The rule permits payment of cash referral fees to individuals and companies recommending clients to an RIA, but requires four conditions are first satisfied.

This is the second in a two-part blog series from David Tittsworth, executive director of the Investment Advisers Association, in which he tells us what he learned during the IAA’s annual compliance conference in the first week of March.In part one of the series, he looked at the legislation, regulation and policies now in place and what's next. In part two below, he looks at the SEC's priorities in examining RIAs.

As I wrote in the first posting in this series, I tend to lump relevant legal, regulatory and compliance developments into two different big boxes. In box one I place the significant legislative, regulatory, or policy developments that are being pursued in Washington, along with a look at what’s coming next inside the Beltway. In the second box I look at the changes being pursued and the initiatives being discussed in the SEC’s inspection and enforcement realm. In this post, we’ll focus on the latter.

Oversight and Enforcement Activities

The second basket of issues relates to the SEC’s oversight of investment advisory firms. I must start by praising the SEC for a heightened level of transparency and information. Carlo di Florio, director of the SEC’s Office of Compliance Inspections and Examinations, his deputy Drew Bowden, and their team have made unprecedented efforts to inform the advisory community of their priorities and potential problem areas. While one can always argue with the details, I applaud OCIE for making the effort to notify investment advisory firms of what OCIE is planning and how firms can be prepared for SEC examinations.

Late last month, Mr. di Florio publicly released OCIE’s “Examination Priorities” for 2013. The document illuminates key aspects of the SEC’s current examination program. Specific to investment advisory and investment company firms, the document lists the following areas of “ongoing risks” when scoping and conducting examinations: (1) safety of assets; (2) conflicts of interest related to compensation arrangements; (3) marketing/performance; (4) conflicts of interest related to allocation of investment opportunities; and (5) fund governance. The document also lists the following “new and emerging” areas of concern for investment advisory firms and investment companies: (1) new registrants; (2) dually registered BD/IA; (3) “alternative” investment companies; and (4) payments for distribution in guise. For anyone who is wondering where the SEC’s inspection program is heading—and what a firm should be looking at to prepare for such a visit—this document is required reading.

OCIE also released a “risk alert” on March 4, entitled “Significant Deficiencies Involving Adviser Custody and Safety of Client Assets.” This important document details the many custody rule deficiencies the SEC has found.

The number of these deficiencies—more than 140—should cause firms to sit up and take notice. They include:

(1) failure by advisors to recognize that they have custody (citing the role of employees or related persons, bill-paying services, online access to client accounts, where the adviser acts as a general partner, physical possession of assets, check-writing authority and receipt of checks made to clients);

(2) potential problems with the surprise exam requirements of the custody rule;

(3) qualified custodian requirements;

(4) audit approach issues.

Obviously, the message here is that investment advisory firms are not understanding or complying with the mandates of the custody rule. Again, this document should be required reading for all advisory firms that take their compliance obligations seriously.

Messrs. di Florio and Bowden also outlined the current examination program OCIE is undertaking in 2013. Here’s the quick and dirty summary:

All examinations are risk-based (based on a risk priority review of all firms based on Form ADV and other available data).

They are pursuing for-cause exams as necessary (based on the agency’s Tips/Complaints/Referral program, as well as from potential whistleblowers).

They are engaged in targeted exams of newly-registered private fund advisers (they have completed 40 such exams with 80 more in the pipeline).

The SEC and its 11 regions also are conducting other risk-targeted “sweeps” that connote some national or emerging issues, including a sweep of mutual funds and their advisers starting this week. They continue to focus on following up in situations where corrective action has been cited in previous exams. OCIE continues to hire and utilize in-house experts and is actively coordinating with the SEC’s other divisions to ensure better information flow and enhance responsiveness, including with the Division of Enforcement.

Let’s wrap this up by noting a few key aspects of the SEC’s enforcement activities specifically relating to investment advisory firms.

The first may be the most important—and underreported—development of the last two to three years. When Chairman Mary Schapiro appointed Robert Khuzami as the head of enforcement back in 2009, he created five specialized units within the SEC’s enforcement division, including an “asset management” section responsible for investigations involving investment advisors, investment companies, hedge funds and private equity funds.

The number of enforcement actions brought by the “new” asset management unit has been unprecedented and sobering: the SEC filed 293 enforcement actions involving investment advisors/investment companies during fiscal years 2011 and 2012, the most ever in a two-year period. This compares to 163 cases during the 2008-2009 two-year period, and 124 cases during the 2002-2003 period. By any measure, these numbers should grab the attention of investment management firms.

All advisory firms need to appreciate the fact that the Asset Management Unit within the Enforcement Division is alive and well. Julie Riewe, an articulate deputy chief of the unit, spoke at our conference and confirmed what the numbers clearly demonstrate : the unit is actively and aggressively bringing enforcement cases against advisory firms and investment companies for securities violations.

Just do the numbers. While the odds of being examined by the SEC may be relatively low (primarily depending on your firm’s risk profile), the odds that serious action may follow an examination is increasingly high.

That’s the news from beautiful Crystal City this week. As always, I welcome and appreciate your feedback, thoughts, and suggestions…